Emerging markets rebound could be short-lived

Opinion: Easy profits could lead to damaging boom-bust pattern

By

MichaelCasey

Columnist

Bloomberg

Emerging markets are caught between the Fed’s rock and the ECB’s and BOJ’s hard place.

In January, jittery global markets worried that the Federal Reserve’s plan to taper its bond-buying would suck money out of emerging-market currencies into dollars, fomenting financial crises and fueling inflation.

Three months later, the opposite force is coming into effect, with money rushing back into emerging markets. If that continues, it could lead to problems of the other kind: bubbles and currency overvaluation.

Markets have acclimatized to a slow and predictable unwind of Fed stimulus while the European Central Bank and Bank of Japan have become the global liquidity providers, all of which is helping restore capital inflows into emerging markets’ currencies. The Brazilian real, Indonesian rupiah, South African rand and Turkish lira are all up between 8% and 11% since their cyclical low points in mid-January.

More speculation

Few will argue that this reversal is unwelcome. The problem is it likely reflects speculators exploiting the gaping difference between rock-bottom developed-country interest rates and the upwardly inclined rates of countries such as Turkey and Brazil more than it does a willingness to make lasting investments in productive industries.

It’s a telltale sign that the “carry trade” is back, a strategy in which investors borrow in low-yielding currencies and recycle the proceeds into higher yielding currencies. Right now, based on central bank benchmark rates, they get money close to zero percent in dollars
DXY, +0.06%
, yen
USDJPY, +0.14%
or euros
EURUSD, -0.0637%
and earn 11% on it in the Brazilian real, 10% in the Turkish lira or 7.5% in Indonesian rupiah. That’s a big spread, but exploiting it has nothing to do with long-term confidence in these countries’ future prosperity.

The last time the carry trade was in vogue in the years following the 2008 financial crisis, the phenomenon spurred talk of a “currency war” as emerging markets grappled with an unwelcome loss of export competitiveness when their exchange rates rose. They complained then that the loose monetary policies of the Fed and other major central banks were driving “hot money” into their financial systems — funds that were liable to flee at the first sign of a policy shift or of greater volatility in global markets. Some opted for capital controls to limit the fallout, prompting investors and foreign officials to lecture them that they should instead focus on domestic inflation and jack up interest rates even higher — uncompetitive exchange rates be damned.

Either way, they couldn’t protect themselves. The minute the Fed aired plans to rein in quantitative easing, the feared outflow materialized, one that many emerging-market policy makers failed to stem even as they reluctantly and belatedly adopted higher rates. All this culminated in the mini-crisis of January, whose climax came when Turkey’s central bank raised a benchmark rate by more than five percentage points in a desperate bid to support the lira.

The question is whether we are repeating the same boom-bust-pattern.

On the positive side, fund tracker EPFR reports a healthy recent inflow into emerging-market equity funds, which suggests investors with a longer time horizon are finally getting in. Emerging-market equities enjoyed net inflows of $2.5 billion in the week ended April 2, reversing a unbroken trend of outflows that led to a quarterly record net outflow of $41 billion in the first three months of the year.

A more important gauge lies in money-market and currency flows, however. And while there’s no timely data on this over-the-counter industry, the earlier and more sizable reversal in currency trends suggests that much of the play on emerging markets is speculative in nature.

After all, the economic data is hardly enticing. Brazil hasn’t been able to get growth above 2% for two years, is hindered by 6% inflation, and has a hole in its fiscal accounts, while its commodity exporters are struggling with slowing demand from China. Turkey, once the darling of foreign investors, has a slightly stronger growth rate but it’s a third of what it was two years ago and inflation is close to 8% while Prime Minister Tayyip Erdogan’s authoritarian instincts are prompting protests and scaring off foreign investors. The story is not much better anywhere else in the emerging-market world.

But investors love easy profits. And when global markets lose their volatility and when policy in the advanced countries promises consistently easy money for long periods, interest rate spreads like those are too juicy to give up…that is, until the mood shifts.

As long as policies remain uncoordinated internationally, leaving each country to struggle alone in a competitive game to manage the fickle intentions of global speculators, these risky buildups will continue.

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